Private Equity for the Masses

By

Brett Arends

Updated March 26, 2010 12:01 a.m. ET

Should ordinary investors entrust their money to private equity?

It's a timely question. Legendary private-equity firm Kohlberg Kravis Roberts & Co.—made famous in "Barbarians at the Gate," the 1980s classic about the battle for RJR Nabisco—is about to list on the New York Stock Exchange. Apollo Global Management, a rival, is pursuing an initial public offering.

Chris Kotowski,
an analyst at Oppenheimer & Co., says the industry is starting to emerge for the first time as a distinct sector on Wall Street. "Much like when investment banks and REITs first started going public," he wrote in a recent note, "the private equity companies are currently seen as 'one-off' oddities, with unfamiliar accounting and no trading history. This should change with time.... We think it's still early, but that the potential is considerable."

Once upon a time, "private equity" was closed to all but the wealthiest individuals and institutions. Now anyone can get a piece of the action. What does this mean for you?

The case for investing in private-equity firms can be put pretty simply. Analysts will tell you that over several decades private-equity investments have outperformed the public markets. The top firms have shown an ability to create serious shareholder value in the companies they buy—partly through financial expertise, and partly by improving operations. If markets and economies continue to recover, goes the story, they should benefit dramatically.

Furthermore, in the wake of the financial crisis, such firms ought to be able to find plenty of bargain opportunities to invest the money in their private-equity funds. Such funds have typically done best on the back of stakes purchased in bad markets, and company valuations remain well below their 2007 peaks—although they have rebounded a long way from the lows of a year ago. KKR has just begun paying dividends, and at current prices offers a decent yield of nearly 3%.

There's a case to be made. But I think all but the most adventurous private investors should probably look elsewhere.

Why?

Here are five good reasons.

First, I'm taking a cue from Groucho Marx. The only private-equity firm I'd like to invest in is one that wouldn't let me.

After all, no matter how you dress it up, private-equity firms make their money by beating ordinary stock investors. They take public companies private for less than they're worth, and then sell them back to ordinary investors for a lot more. Even if they aren't trying to sock it to ordinary investors, they are hardly in business to leave a lot of value the table.

Why would anyone buy shares in a private-equity firm that the insiders were willing to sell?

Just look at the record.

The IPOs of Fortress and Blackstone three years ago were signs the equity bubble was nearing its peak. Those who invested in Fortress when it went public have so far lost three-quarters of their money. In the first two years after the offering, the stock plummeted 95%. As for Blackstone, the stock has halved since the IPO. Even when you include dividends, ordinary investors have lost more than $2 billion. (The Chinese government also got hosed: It bought a 10% stake around the same time through the inaptly named Beijing Wonderful Investments.)

In the case of KKR, the good news is that the firm is not raising any money in its forthcoming New York IPO. Instead, the company is transferring an existing listing from Euronext Amsterdam. But Apollo is raising money. And the main reason KKR is moving its listing to New York is for the liquidity. That will make it much easier for insiders to realize some value on their stakes by cashing out when they need or want to. Anyone who invests had better follow the insider stock sales pretty closely.

The second caveat is that, as mentioned here before, it makes sense to be wary of investing in Wall Street firms. This is not merely a matter of trust, either.

As in most Wall Street firms, the lion's share of the value is almost certainly going to end up in the hands of star employees rather than you. And why not? There is a free market for talent, and these people do not succeed by leaving money on the table. They can always leave if they get too little. Ordinary stockholders and mutual fund investors are a dime a dozen. Real rainmakers, on the other hand, are scarce.

The third problem is that private-equity firms, like most financials, are what is known as "procyclical." Broadly speaking, they are most apt to boom when the economy is booming and slump when it's slumping. Alas, that's probably also the case for your own finances. When the economy is down you probably aren't getting a pay raise at work. Your 20-something children are more apt to be living at home, unable to get a good job. The value of your home is probably down too. Do you really need more boom and bust in your life? (The corollary of this is that the best time to invest in these types of stocks is during the depths of a panic—which is precisely when you can least afford to.)

Fourth, it's always dangerous to invest in something you don't fully understand inside and out. And in the case of a private-equity firm, that's harder than with most investments. The preferred measure of quarterly profit at private-equity firms is "economic net income," rather than ordinary net income or something as humdrum as cash flow. And even the precise value of assets and liabilities at any given moment can be subject to dispute. As an investor, what you don't buy often turns out to be more important than what you do—and as many have found to their chagrin in the last few years, the risks of investing in financials have frequently outweighed the rewards. In stocks like these, it is next to impossible for an outsider to find an edge.

But the fifth and final problem with investing in these firms may be even more fundamental.

Private equity is too crowded. A flood of cash has poured into private-equity funds in recent years. And regardless of what the hype or consensus may tell you, that means returns are unlikely to come anywhere near what they were in the past. The laws of supply and demand are not complex.

How bad is the picture? According to London-based financial-research firm Preqin, private-equity funds around the world have raised a staggering $950 billion in the last five years. The comparable figure from 10 years ago was just over $222 billion. And in the early 1990s, it was a mere $50 billion.

No wonder private-equity firms did so well during the 1980s and '90s. There weren't many of them around, and they didn't have much money to invest. They had their pick of deals.

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